7 Stocks Set To Surge On Secret Earnings Pattern

Second-quarter earnings season was a bit of a bust. Although earnings remain at an all-time high, the pace of earnings growth continues to look weak. Earnings growth is up just 3% from last year, a small improvement from the first quarter's 2.6% gain and the 2.8% average for the past four quarters.

The headlines reflected that disappointment, with stories about the biggest blue chips struggling with the weak global economy and falling short of expectations. That includes misses from bellwethers like IBM (NYSE: IBM), Google (Nasdaq: GOOG) and Microsoft (Nasdaq: MSFT).

But in spite of some earnings headwinds, there were a number of companies that bucked the trend and delivered big earnings surprises. For instance, take Facebook (Nasdaq: FB), which delivered a 44% earnings surprise last month that sent the company's share price soaring.

But if you missed out on that first leg higher, don't worry, because according to a little-known and understood pattern, there is still more upside in Facebook.

According to the post-earnings drift, firms with good quarterly earnings reports tend to see returns drift upward for at least 60 days after their announcements. Similarly, firms that report disappointing earnings tend to drift lower for a similar period.

You can see that pattern play out in Facebook, with shares initially jumping to $34 before drifting another 20% higher in the next three weeks.

A strong earnings surprise will have an immediate impact on a company's share price as short-term players scramble to be the first to market. But that is merely the first wave in a series of bigger waves, as larger long-term investors like hedge and mutual funds shift money into new targets based on new information. That can keep billions in capital flowing into a stock for weeks and months after an earnings surprise.

The post-earnings drift enables investors to bypass the guesswork of identifying which companies will produce earnings surprises and focus on simply buying ones that have already surprised to the upside instead. That means missing the first, big move higher, but it also increases the likelihood of a profitable investment or trade.

From the group I have chosen to highlight Forest Laboratories (NYSE: FRX) because of its bullish growth projection and Chesapeake Energy (NYSE: CHK) for its attractive valuation.

Forest LaboratoriesForest has looked solid in 2013, with shares up 23% on the year. The branded drugmaker got a big boost in late June with record fourth-quarter results that produced earnings of 28 cents per share, well ahead of the consensus estimate of 7 cents. Forest is in the early stages of a long-term growth cycle, expected to increase earnings by an average of 36% annually in the next five years. But in spite of those high expectations, Forest's price/earnings-to-growth (PEG) ratio of 1.02 is a discount to its peer average of 1.21 and in line with the benchmark for value of 1.

Chesapeake Energy Chesapeake is looking like one of the best turnaround stories of 2013, with shares up a market-beating 51% on the year. That comes on the heels of a busy 2012 when activist billionaire Carl Icahn took a large stake and agitated for change, leading to the firing of the company's founder and longtime CEO and the sale of assets to raise cash and supportliquidity. Those strategic adjustments have paid off big, with Chesapeake reporting a 31% earnings surprise in its most recent quarter. Chesapeake is projected to increase earnings by 30% annually in the next five years and carries a 1.3% dividend yield.

Risks to Consider: Stocks that deliver big earnings surprises tend to carry higher expectations and trade at higher valuations. Any future earnings misses or weaker than expected forecast can weigh heavily on shares that have rallied on bullish growth projections.

Action to Take --> In spite of Chesapeake's impressive 51% gain in 2013, shares still look undervalued, trading with a forward P/E (price-to-earnings) ratio of 16. If Chesapeake traded with the same forward P/E of 18 as its peers, shares would climb another 13%, making Chesapeake a buy below $27.50. Forest Laboratories is expected to increase earnings by 36% annually in the next five years, targeting full-year earnings of $4.51 in 2018. If Forest simply traded with the same valuation as its peers, that would send shares soaring to $72, a 67% premium to current levels.

P.S. -- It's great to hold a stock long enough to ride a post-earnings drift higher -- but it's even better to find stocks solid enough to buy, forget about and hold -- forever. My colleague Elliott Gue and his staff recently went looking for the absolute best "Forever Stocks." After six months and $1.3 milllion worth of research, the team was successful. To learn more about the "Forever" stocks that they uncovered -- including some names and ticker symbols -- click here.